Are Loan Points a Tax Deduction?
Are points tax deductible?
Loan points sometimes get a bad rap, even when they might be tax deductible—and many loan points are deductible if you follow the rules.
Try to wrap things up by Dec. 31 if you're planning to buy a new home around year’s end. The reward for meeting that deadline is a tax deduction for the year if you have to finance the purchase with a mortgage loan on which you pay loan points.
How Do Loan Points Work?
Points are additional, up-front fees that are paid instead of higher interest rates. Lenders routinely charge points when money is scarce, also known as "loan origination fees," "premium fees,” or "loan discounts.”
One point equals 1% of the amount borrowed. You've paid $3,000 if you borrow $300,000 and pay one point.
How Do Loan Points Qualify as a Tax Deduction?
The key to loan points being 100% deductible in the year of payment, along with your other home-mortgage interest, is that you pay them to obtain a specific type of loan.
It must be a loan to buy, build or improve your main home, such as if you add or remodel a room. The home generally can't be a property for which you charge rent.
Refinancing points don't count if you use the money to take cash out for a purpose that's unrelated to your home. The funds must be used to "purchase, construct, or substantially improve" it, according to the IRS.
What Does the IRS Say About Loan Points?
Refinancing points are not deductible in full in the year you pay them unless they're paid in connection with the purchase or improvement of a home. This is true even if the new mortgage is secured by your main home.
Refinancers must write points off in dribs and drabs over the life of the loan, dividing the points paid by the number of monthly payments to be made over the life of the loan.
If you pay $4,000 in loan points and will make 360 monthly payments on a 30-year mortgage, your allowable deduction is $11.11 per payment, or a total of $133.33 for 12 payments.
This IRS allocation requirement was backed up by a 1988 Tax Court decision, although the Eighth Circuit Court of Appeals rejected the allocation rule when points are paid on long-term mortgages that replace a short-term loan with a balloon payment.
Take a deduction in the payoff year for all remaining points not yet deducted when you're refinancing a second time, or if the loan is paid off early.
The lender has to report to the IRS the amount of points paid directly by a borrower, other than refinancing points. The amount must be listed on Form 1098, which is sent to the IRS which then compares these 1098 figures with amounts listed as deductions for points by taxpayers on Schedule A of Form 1040.
What About Seller-Paid Loan Points?
Other complications kick in when you're the seller and you pay points to induce the lender to arrange financing for the buyer.
You can't count these points as interest, but they do reduce the amount of any gain you realize from the sale. The buyer must subtract the amount paid from the purchase price in computing the home’s basis—the figure used to determine capital gain or loss on the sale of an asset.
Are Prepayment Penalties Tax Deductible?
Be mindful of another wrinkle if you prepay the mortgage on a principal residence only to be hit with a hefty penalty, a percentage of the unpaid balance, for the privilege of paying it off ahead of time.
That extra charge is fully deductible home mortgage interest, no matter what the lender calls it.
Julian Block is an attorney, syndicated columnist, and former IRS special agent. This article was largely excerpted with permission from the pamphlet "The Home Seller's Guide to Tax Savings: Simple Ways for Any Seller to Lower Taxes To The Legal Minimum," which can be ordered from J. Block, 3 Washington Sq., #1-G, Larchmont, NY 10538.
At the time of writing, Elizabeth Weintraub, CalBRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.